I had earlier written an article presenting my case for VIX and volatility ETP (VXX, XIV, SVXY, UVXY) end prices for September expiration. This article presents an investment case (or, more accurately, lack thereof) for volatility ETPs following up to my previous article.
What should volatility investors do between now and September expiration? My advice is:
I repeat, do nothing. Sit tight in cash. Wait for the following movies to play out first before you feel it is safe to go back into the water.
Movie 1: Taper Madness
As we all know, the US Fed has decided to start tapering QE, and will likely announce that they will trim bond purchases from $85B/month to $75B/month starting in, likely, September Fed meeting. If they don't announce it in September, it will likely be the December meeting. I will not go into whether it makes sense to taper (I think it doesn't, as the economy is nowhere near strong). I will not go into whether taper will have an impact on bond prices, and hence stock prices, and hence volatility (it shouldn't, given rates have already adjusted in anticipation of taper). I will instead focus on what will likely happen when the Fed announces taper.
Let me present one simple fact here that I think is important to understand volatility movements. The market is driven by professional investors. Professional investors as a group are good at two things. The first is to underperform the market index, and the second is to panic at every opportunity. So I believe when the September FOMC meeting arrives, there will be a spike in the VIX. It may fall right after that and we may get a relief rally, but rise it will in anticipation.
Movie 2: Missiles over Damascus
As well all know, once again, the US Govt is between a rock and a hard place. Quite admirably, President Obama has so far kept the USA out of the Syrian civil war. However, he made a stupid commitment earlier, that if the Syrians use chemical weapons then all bets are off. The calculus, therefore, was that the Syrians will keep killing hundreds of thousands of their own citizens using conventional weapons but not kill a thousand or two of the same using chemical weapons, thus providing the USA with a face saving opportunity, enabling it to talk tough while not taking action.
But someone forgot to send the Syrians the memo, and they went ahead and used chemical weapons.
This is a major inconvenience for the Obama administration. It has to take action now. Thankfully, the cost of taking action is not high. Rumors are that we are talking 50-100 missiles, at a cost of $1M each. $50-100M is not a lot for a $15T economy, and this also means replenishment of the missiles will be good business for its manufacturer. However, once again, professional money managers are trained to panic, so panic they will, which will push VIX higher.
Movie 3: Default House
So we are there once again, and talking about the debt ceiling. The US Govt has been deficit spending for the past 30 years, and we need to borrow more to keep the wheels of the Govt running, as well as to roll over our debt and pay interest. However, a group of Freshmen Congressmen (or are they Sophomores now?) of a certain political leaning wants the USA to default on the loan.
Of course, when you read the above, you may think that I am either insane, or making a really bad joke, but in all seriousness I am not making this up. The Tea Party Republicans want significant concessions from President Obama, primarily in the area of Universal Health Care. Since they couldn't stop Obamacare legislatively after trying a few times, they want to take the opportunity of the debt ceiling crisis to bargain and defund Obamacare.
The first step of course would be to shut down the Federal Govt, but these politicians know what happened to Newt Gingrich in the 90's when that stunt was tried. The Republicans lost the House. So they have decided that shutting down the Govt would be a wrong move. Instead, they are talking about forcing the US to default on its debt instead.
This is serious business, and last time crazy talks like this were in full swing in 2011, S&P downgraded the US debt, and VIX spiked to the 40s. Of coruse, there will be no default. But volatility will spike no matter what.
Movie 4: The Madness of Chairman Larry
This is an also ran to some extent as far as volatility moving news is concerned, but to me this is the highest risk to the US economy and the markets in the near future. There is a 65% chance that Larry Summers will become the next Fed Chairman. The markets want Janet Yellen, who is dovish, while Larry is hawkish.
Personally, I think Summers will be a horrible choice as 1) he is a deregulator and what we need today is tough regulation of the banks who are run by not so smart people who are also very greedy, and 2) he made a mess of the Asian crisis in the 1990's by forcing austerity on all those countries, which delayed their recovery per the IMF.
That austerity doesn't work is known to any economist, but that Summers kept ignoring all his education shows to me that this is not a person you want in the second most important job in the USA. Summers defenders may point out that he was in favor of massive Keynesian spending in the USA and that he only wants to apply austerity to poor third world countries but wants America to prosper by shunning austerity. May be, but Keynesian public spending will not happen till the Republicans lose the House in 2014, and in the mean time we need the Fed to be dovish.
Summers, if anything, is not dovish. I expect markets to tank and VIX to rise if Obama names him as Fed Chair.
So there you have it, 4 movies that are likely to push up VIX in the next couple of months. Hence, I advice readers to do nothing on VIX ETPs in that timeframe. If you are into making money by shorting VXX or buying XIV, don't expect such trends to continue in the near future. So, best to sit on your hands, and watch these 4 movies play themselves out. When there is a good VIX spike, to 25 and higher, then normalcy will resume in the volatility ETP markets. If you are itching to invest, buy some VIX calls in the interim.
While you are waiting for that VIX spike, why not watch the real movies based on which I wrote this article? They are Reefer Madness, Bullets over Broadway, Animal House, and The Madness of King George.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.